Support from Bank of Israel drives sharp rebound in shekel

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The Israeli shekel is the world’s top performing currency this month, driven by billions of dollars of purchases by the central bank since the outbreak of the war with Hamas.

The currency has risen by around 8 per cent in November to 3.74 shekels per dollar on Friday, more than reversing a fall of nearly 6 per cent in the first 20 days of the conflict when investors took fright at the potential for a war to escalate across the Middle East. 

The rebound is a sign that investors believe the war will remain contained while also reflecting confidence in the Israeli government’s strong balance sheet and the bank’s willingness to defend the currency. The currency has also been supported by billions of dollars of financial inflows from abroad.

Line chart of Shekels per $ (inverted scale) showing Israel's currency has more than recovered from its October slump

“The rally reflects the easing of geopolitical tensions, especially perceptions that the risks of spillovers from the conflict in Israel into the wider region have eased,” said Oliver Harvey, a senior FX strategist at Deutsche Bank. He added that the shekel “typically performs well with higher US equities and we have seen a big rally over the last month”. 

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The recent rally has also been fuelled by an unwinding of “extreme” short positioning — bets on lower prices — and the Bank of Israel’s willingness to use reserves to offset excessive currency weakness.

Earlier this month it disclosed its reserves had dropped by $7.3bn in October as it sought to defend the shekel against further declines.

“The BoI did a pretty good job defending levels beyond 4.00 per US dollar and the disclosure of central bank FX [currency] intervention firepower managed to suppress speculative short shekel flows,” said Luis Costa, head of emerging market sovereign credit at Citibank. 

Attention will now turn to the central bank’s monetary policy decision on Monday, with a stronger currency giving it more room to cut interest rates as economic growth is hit by the war against Hamas.

The BoI — which targets an inflation rate of between 1 and 3 per cent — has kept interest rates at 4.75 per cent since May, over which time Israel’s annual headline inflation rate has cooled from 4.6 per cent to 3.8 per cent.

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Markets are currently pricing in only a small probability of a rate cut at the meeting on Monday, but anticipate that a reduction is likely within the next three months.

S&P Global Ratings this week forecast a 5 per cent contraction for Israel’s economy in the last three months of this year. The BoI has already lowered its growth forecasts for the year to 2.3 per cent. 

Last week JPMorgan said it expected Israel to run a budget deficit of 4.5 per cent next year, up from a previous forecast of 2.9 per cent. 

Costa said there was a “good likelihood” the BoI would start cutting interest rates in the first quarter of next year. This “may spark a new mini-cycle of shekel weakness”, which would be amplified by any weakness in the global technology services sector, an important sector for Israeli exports. 

But Kamakshya Trivedi, head of global FX at Goldman Sachs, said that at current levels the shekel was “still undervalued” owing to declines earlier in the year, when investors were focused on uncertainty around judicial reforms. 

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“Valuations, per se, are not an obstacle for further appreciation if geopolitical risks de-escalate and global tech stocks continue to trade well,” he said.